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Market imbalances eventually balance.

By Michael Weinberg

In 2011 the HFI Equity Index was down 4.39% while the
S&P 500 Total Return Index was up 2.1%. In 2012 the HFI
Equity Index was up 6.13% and the S&P Total Return Index
dramatically outperformed, rising 16%. During the past two
years a near consensus industry view has emerged that equity
long/short investing is dead. This view was espoused in trade
press and in more general financial periodicals as well as at
leading industry conferences. On a panel at one of these
conferences, an industry veteran went as far as asking why
investors were in the strategy at all given the disappointing
returns and higher fees vs. long-only.

The rationale as to why returns have been disappointing
typically goes something like this: increased competition,
record assets in the strategy, and macro-driven markets with
high correlation and low dispersion. We agree with most of
these points; however we strongly disagree that this means
equity long/short is dead, as such a conclusion misses a core,
fundamental point about the strategy and the markets.

It is true that we are back to near-record assets in the
equity long/short strategy. Peak yearend assets in equity
long/short hedge funds according to HFR were $685 billion at
the end of 2007. At the end of the most recent quarter, they
were $600 billion. Irrefutably, competition for the best trades
is a factor. However, though it is difficult to quantify, we
believe if one were to add investment bank proprietary trading
capital to the two asset levels, industry assets are materially
below the record levels likely achieved in the strategy in
2007. As for the markets, in 2011 and 2012 they were highly
macro driven. The Euro crisis resulted in extraordinarily high
volatility, and large and correlated moves, often on a daily
basis. For example, record intraday percentage moves in the
S&P 500 occurred with greater frequency in 2011 than in any
year since the index began. Correlations were extremely high
and dispersion similarly low. Equity markets behaved in a
binary manner with risk-on or risk-off, and only more
occasionally there was a third state: risk-neutral.

This confluence of events resulted in stocks behaving in a
remarkably similar manner irrespective of their fundamentals,
which is the worst environment for most equity long/short
managers. In simple terms, these managers try to make a spread
on longs and shorts. In an extreme example, not too different
than last year, when all stocks are moving up (or down) and
mostly in similar magnitude, there is no spread for these
managers to exploit. Or worse, when stocks are not trading on
fundamentals, technical factors can drive down the prices of
cheaper companies and drive up the prices of expensive ones,
resulting in losses for managers with market neutral books.

So why would one continue to invest in equity long/short?
For the simple reason that high correlation and low dispersion
represent market imbalances, and a fundamental fact about
market imbalances is they eventually balance. In other words,
dispersion and correlation are mean reverting. Though neither
we nor anyone else can accurately predict exactly when these
variables will mean revert, we know it is only a matter of time
before they do. Of course the caveat is that like any market
imbalances they may persist for long periods. Similarly we have
no doubt that at some point this type of inhospitable
environment for long/short investors will re-emerge.

Though these periods of imbalanced markets may be unpleasant
in the short term for equity long/short managers, the more
important point is that they are a necessary evil for the same
managers to produce outsized returns over the longer term. Here
is a hypothetical example to illustrate why that is. Imagine a
zero sum game duopolistic industry where one company is well
managed and its competitor poorly managed. Over time the winner
will gradually increase its market share, revenues,
profitability, cash flow and balance sheet strength; and the
loser will experience deterioration in all of these metrics. In
an "ordinary" market rational investors notice this and would
buy the winner and sell (or short) the loser. These two stocks
would likely trade "normally" with a premium valuation ascribed
to the winner and a discounted valuation to the loser. For
purposes of this example, let us assume that the winner would
trade at a deserved 20% premium to the loser based on
fundamentals.

In a market environment driven by technical factors, with
high correlation and low dispersion, these stocks would trade
similarly. Let us assume they both go down by 20% and the
disparity in their underlying fundamentals would not be
reflected in the price. For an equity long/short manager who
had a pair trade on (long the winner, short the loser) there
would be zero net returns until the disparity is corrected.
However, though no profit is being made, an outsized future
return is being created. The short could be covered down 20% at
a 20% profit (assuming the sale prices is the cost basis) and
the long held on to. When the markets trade once again on
fundamentals, assuming the long achieved its prior valuation,
the long could be sold up 25% at a 25% gain. This would result
in a 45% return on the trade. Opportunities like this are
created specifically from imbalanced markets where there is a
delay in changed company fundamentals showing up in stock
prices.

In general, there will always be companies that are well run
and poorly run and overvalued and undervalued. Equity
long/short managers are set up specifically to exploit these
inefficiencies, whereas benchmark constrained long-only
managers have limited flexibility to do so. Thus equity
long/short managers have a different source or returns than
long-only managers, and for investors looking to diversify
their portfolios and limit equity beta, the strategy remains
attractive. To maximize value from equity long/short and
compound capital at attractive rates of return, investors
should select managers that have a consistent repeatable
process with strong risk management, enabling them to exploit
inefficiencies over a market cycle. Investors will need to
acknowledge that for short periods environmental factors may
preclude profitability, but should also understand that these
periods of imbalance have an important role in generating
future returns. This is why we are comfortable that equity
long/short investing is not dead and never will be.

Michael Weinberg is an adjunct associate professor of
finance and economics at Columbia Business School. He was
formerly in charge of equity and event allocations at
multistrategy fund of hedge funds firm FRM where he served on
the investment and management committees.

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